February 11, 2000
The Credit Bubble Bulletin by Doug Noland
If Minsky Were Alive Today
It was a particularly unsettled and ominous week for the financial markets. Ironically, the extraordinary period of wild speculation runs unchecked with the semiconductors jumping 5% and the AMEX Biotechnology index rising 8%, increasing these respective indices' year-to-date gains to 30% and 31%. Both the NASDAQ100 and the small cap Russell 2000 increased 2% this week, as their 1999 gains rose to about 7%. The NASDAQ Telecom index advanced 4%, The Street.com Internet index 1% and the Morgan Stanley High Tech index was unchanged. The bluechips, on the other hand, came under considerable selling pressure. The Dow was hit for 5%, while the S&P500 declined 3%. The economically sensitive sectors were hammered with the Tranports and Morgan Stanley Cyclical index dropping 7%. The Utilities and the Morgan Stanley Consumer index both declined 3%. Dislocation in the credit markets continues to put pressure on the financial stocks, as the S&P Bank index and Bloomberg Wall Street index sank 3%.
In the credit market, the long bond fluctuated wildly throughout the week while suffering through one of its worst auctions in memory. We see this week's poor auctions as important evidence of faltering liquidity. Bond yields rose 11 basis points, with 5-year Treasuries jumping 5 basis points to 6.72% and the key 10-year note jumped almost 13 basis points to 6.69. Unusually wide spreads also continue to provide evidence of systemic stress. Commodity markets are unsettled as well, particularly in the important crude oil and precious metals markets where prices continue to move higher. The dollar is proving quite resilient thus far, but remains vulnerable to faltering US financial markets. We certainly expect another week of unsettled markets, exacerbated by next Friday's option expiration.
If only Hyman Minsky, the great economist and monetary theorist, were alive today. If so, we think he would comprehend today's extraordinary environment like few others - he would have it "wired" while the vast majority of economists fixated on productivity data and the "new paradigm". Importantly, Minsky was always keenly focused on the financial system - on the institutional nature and financial structures that evolve naturally to create an increasingly unstable system over the life of a boom. As such, during the 1960s, as many economists were focused on what they saw then as a "new era," Minsky developed the "financial instability hypothesis" while analyzing the causes of the Great Depression and pondering whether a similar catastrophe could be repeated.
We were first introduced to Minsky's analysis reading Charles P. Kindleberger's classic "Manias, Panics and Crashes..." For much more on Minsky we also strongly recommend the excellent material available from the Jerome Levy Institute at www.levy.org and, particularly, the fine analysis of Levy's Dimitri B. Papadimitriou and L. Randall Wray.
From their work, The Economic Contributions of Hyman Minsky, comes a most important and profoundly pertinent concept: "A financial system naturally evolves from a robust structure to a fragile structure, or from a structure that is consistent with stability to one that is conducive to instability...According to Minsky, financial positions evolve from "hedge" (backed by ample and stable cash flows) to "speculative" and finally to "Ponzi" finance, first as expectations about future returns become increasingly optimistic, and later as expectations are disappointed or financial arrangements are disrupted."
Quoting Minsky: "It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system...Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance."
This profound analysis provides invaluable insight for those seeking a clearer understanding of the current precarious financial and economic environment. Indeed, if Minksy were alive, he would undoubtedly believe that we are today at the precipice. Remember, it was only sixteen months ago in October 1998 that our financial system teetered at the edge with the collapse of Russia, Long Term Capital Management and systemic illiquidity. And it was only last fall that our credit market again came under significant stress as spreads widened to the levels not seen since the 1987 stock market crash and a problematic dislocation unfolded in the gold market. In both instances, however, the inevitable consequences of too much debt and too much leveraged speculation - "Ponzi finance" - were temporarily resolved by the creation of only more debt and leverage. A truly extraordinary period of credit creation, particularly instigated by the Government-Sponsored Enterprises, reliquefied the credit market and perpetuated the boom. This allowed historic speculation in the Internet, telecom, biotech and NASDAQ, generally, as well as trillions of dollars of new debt.
If Minsky were alive today, he would certainly protest the momentous bailout efforts by the Fed and the GSEs. He would view such aggressiveness as recklessly exacerbating the already highly unstable financial system, rife with over-leverage, speculation and "Ponzi finance". In fact, Minsky was a staunch believer that it was essential that banks and companies be allowed to fail to ensure that market discipline was maintained. He would certainly argue that actions by the Federal Reserve and the GSEs have worked to subvert market discipline at a momentous cost of a system now acutely prone to major financial and economic dislocations. In this regard, a quote from Minsky: "Every businessman and banker knows that for every investment project worth undertaking, there are literally an infinite number that are losers. Once the doctrine of salvation through investment becomes deeply ingrained into our political and economic system, the constraints on foolish investment are relaxed. This is especially so if the government stands ready to guarantee particular investors or investment projects against loss."
With each passing year of this historic boom, ever more egregious credit excess creates debt of an increasingly dubious nature and a more precarious financial and economic environment. The longer this bubble has been allowed to expand, the more excessive the leverage that has developed throughout the financial system and economy. As we have stated before, our financial system has a dangerous proclivity "to create too much paper of increasingly poor quality." The inevitable consequence is today's very fragile US credit market and distorted economy. Our view is in the spirit of Minsky, as we see from a quote from Manias, Panics and Crashes, "...Minsky is correct in emphasizing the quality of debt in gauging the fragility of a financial structure. An edifice of debt contracted to finance very risky ventures is unstable. Both assets and liabilities can be and should be judged by quality as well as quantity. ...in periods of euphoria, the quality of debt deteriorates, even though the quantity of money may be growing at some appropriate, limited rate."
If Minsky were alive today, we believe he would be quite sympathetic to our view that unprecedented money and credit excess, instigated by a financial sector increasingly dominated by over-zealous non-bank institutions, is at the heart of a frail US prosperity. In the section "money in economic activity" written by D. Foley in The New Palgrave Dictionary of Economics, we found an interesting discussion. "Hyman Minsky puts forward a theory of the relation of money to economic activity in which qualitative changes in the private issuance of monetary liabilities plays a central role. In Minsky's view, firms issue liabilities to finance production based on uncertain (and not necessarily self-fulfilling) expectations about future profitability. As an economic expansion develops, these expectations become more buoyant, and more liabilities are issued. This process gradually erodes the quality of the liabilities, because there comes to be a larger and larger probability that profit realizations will not in fact allow all the commitments to be met. Each firm tends to move towards thinner and thinner margins of equity in its financial position; firms that are reluctant to follow this policy find themselves severely punished competitively in the short run. The deterioration of the quality of liabilities sets the stage for a financial crisis, in which many firms face difficulties in meeting their commitments, and new lending is extended only on much tougher terms."
Likely, Minsky would, as we do, focus on the profound changes that have evolved in the US credit system, with the advent of such credit creation-enhancing mechanisms such as mortgage and asset-backed securities, derivatives, aggressive non-bank lenders and the proliferation of money market funds, equity mutual funds and leveraged speculation. We believe the Federal Reserve has failed in its role as protector of the soundness and stability of the US financial system in the face of such momentous developments. Perhaps Minsky would view the related surge in debt as a momentous change to the financial system - an "initial displacement" instigating a fateful boom.
From Minsky: "Every disaster, financial or otherwise, is compounded out of initial displacements or shocks, structural characteristics of the system, and human error. The theory developed here argues that the structural characteristics of the financial system change during periods of prolonged expansion and economic boom and that these changes cumulate to decrease the domain of stability of the system. Thus, after an expansion has been in progress for some time, an event that is not of unusual size or duration can trigger a sharp financial reaction. Displacements may be the result of system behavior or human error. Once the sharp financial reaction occurs, institutional deficiencies will be evident."
And our final quote from Minsky is one of our favorites, one we believe very strongly, although we think it appropriate to also read "GSE's and non-bank lenders" where he writes "banks": "The shift toward speculative and even Ponzi finance is evident in the financial statistics of the United States as collected in the Flow of Funds accounts. The movement to "bought money" by large multinational banks throughout the world is evidence that there are degrees of speculative finance: all banks engage in speculative finance but some banks are more speculative than others. Only a thorough cash flow analysis of an economy can indicate the extent to which finance is speculative and where the critical point at which the ability to meet contractual commitments can break down is located."
Today, the bottom line is that a "thorough cash flow analysis" of the US economy clearly illuminates household and corporate sectors that have accumulated mountains of debt, as well as a financial sector that could not be more over-leveraged and susceptible to crisis. Unfortunately, it is our view that, indeed, crisis has now returned to the maladjusted US financial system. Not surprisingly, the focal point for the unfolding turmoil is the credit market that now appears to be in the initial stages of a problematic dislocation. The proliferation of financial speculators from sub-prime finance companies to the leveraged speculating community will now face an acutely difficult period with a confluence of rising rates, wider spreads, wild volatility and faltering liquidity. Such an unsettled environment is not conducive to highly leveraged balance sheets or to sophisticated trading strategies. There will be casualties and there will be heightened systemic stress as some impaired speculators are forced to deleverage. Over the coming weeks, we also expect that the "wild cat" derivatives market will be severely tested and that problematic illiquidity will become a mainstay for the US credit market. This will prove particularly problematic for many companies that owe their fortunes to what has been a period of extraordinary liquidity-driven speculation. In a truly amazing development, many of the stocks and sectors that have been at the heart of recent historic speculation, are, in fact, the most vulnerable to the unfolding financial turmoil. It is going to be an historic period, one that would certainly captivate the great analytical mind of Hyman Minsky, were he alive today.